Conversation with Euan Munro, a director of Standard Life Investments, is sprinkled with the sort of phrases one might expect to hear from a hedge fund manager.

Euan Munro

The Fife-born, long-time Edinburgh resident speaks fluently in the language of global macro hedge funds. “US forward-start duration”, “large-cap/small cap relative value” and “Russian equity exposure” trip readily off the tongue. But it would be a mistake, he says, to confuse the Global Absolute Return Strategies fund he manages with a hedge fund. The two are not the same.

There are similarities, he acknowledges. But to really appreciate the difference, he said, you have to go back to 2003, the tail-end of the bust that followed the technology boom, when investors were recording losses even if their fund managers beat their benchmarks.

He said: “I was going into lots of client meetings. We’d done everything that could have been expected of us contractually, but the clients were very unhappy because their investment returns were negative. We needed something that would make them happy. I don’t think any industry has a future unless, when it does what it says it’s going to do, the client is happy.”

The typical UK pension scheme’s approach to investment was then, and often still is, to have a core portfolio of mostly equities and some bonds, in proportions that barely changed from year to year. Investors used hedge funds and other alternative investments as a way of adding returns at the margin of their portfolios.

There was talk, at the time, about using alternative investments even more, increasing the allocation to hedge funds from, say, 2% to 5%. Munro’s insight was to see this as a sideshow.

He said: “I looked through the other end of the telescope. It was the core that was wrong. You can have as much excitement as you like at the margin, but it won’t help you if the core is fundamentally unattractive.” Clients were invested in equities because they wanted to earn an equity risk premium.

Munro believed he could design a way to deliver that return with less risk – to give them a better core. Working with a team at Standard Life Investments, he spent two years developing Global Absolute

Return Strategies, Gars, to generate positive returns over rolling 12-month periods, and give an average
return of London interbank offered rate plus 5% a year, before fees, over three years.

Hedge fund techniques

To do it, he said, he brought in many of the techniques of hedge funds, and put them to better use.
He said: “You have to have a reasonable fee structure – you can’t charge two and 20 [hedge funds used to charge 2% management fees and 20% of performance gains]. Investors need a reasonable return from taking reasonable risks, they need reasonable fees, daily liquidity and something that fits into a regulatory structure.”

The fund typically has about 30 different investment positions at any moment. Recent positions have included long 30-year US Treasury futures and short 10-year Treasury futures – known as the US forward-start duration trade – which made money when US 30-year yields hit record lows in September.

That month, the Gars team of 20 put on another trade, long of the Nasdaq – US tech stocks – and short of the Russell 2000 – US small-caps. Standard Life Investments’ equity teams observed that companies generally had plenty of cash. Munro’s team believed they were likely to spend it on technology, to the benefit of tech stocks. Overall economic growth was likely to be low, which typically hurts small caps.

Munro said: “You want to buy what companies are going to buy before they do. They are looking for efficiency savings. Their first phase of this was redundancies, but that’s more or less done. The second will be spending on technology.”

Another trade took a long position in the Norwegian krone versus a short position in Swiss francs. This paid off when, in September, the Swiss National Bank said it would put a ceiling on its currency appreciation. A more obscure trade was going long Polish zloty and short Czech koruna.

Capacity

At £9bn, investment consultants have questioned whether Gars can take in more money without diminishing its clients’ returns. Anyone worried by this would be alarmed to see that, last month, Standard Life Investments signed distribution agreements to promote Gars in the US and Sweden. Munro said capacity is not an issue: “We’ve had no trouble moving in and out of positions.”

Even with exotic currencies, such as zlotys and korunas, there hasn’t been a problem, Munro said: “We’d never have more than 2% to 3% of the portfolio invested in something like that, so not a large position compared with the size of the market.”

Everything the Gars has done is consistent with a fund of at least tens of billions of pounds, Munro said, and he sees no reason why it shouldn’t be much larger. He regards the competition as Pimco, with an absolute return fund approaching $300bn, and Bridgewater, with a fund of more than $100bn.

Since its launch mid-way through 2006, Gars’ returns have been close to its target of Libor plus 5% with no down years. Over the five years to September 2011, the latest Standard Life has made available, it made 7.8% a year before fees, while Libor was 3.3%, and rolling 12-month returns have mostly been positive. Standard Life Investments declined to give any detail on its fees. It has not been the highest performer in its class – Ruffer, a London fund manager, made 11.2% a year over the four years to September, according to figures collated by investment consultant JLT, while over the same period Gars made 6.5% – but it has been one of the leaders.

Competitive advantage

Part of the reason why Gars has made money, Munro said, is that some participants enter parts of the market without seeking to make a profit. He said: “These actors are often taking positions to protect their balance sheets. American insurance companies may overpay for protection in government bond markets.”

Ideas also come from discussions with Standard Life Investments’ other investment teams, focusing on equities or fixed income.

Standard Life Investments’ position as a large investor – the business runs £157bn – gives it insight others might not have, according to Munro: “When you’re a major bond investor like we are, when it comes to the time when governments auction their bonds to the marketplace, people like us will be in touch with all the marketmakers, have an idea of demand, and we’ll have quite a detailed picture. Around set pieces like bond auctions we feel we have an opportunity to make some money for our clients.”

More generally, however, the Gars team hopes to tap into themes that will emerge and run over the course of two to five years. The breadth of their backgrounds helps them look at things from different angles. A degree in physics and electronics has helped Munro – the maths behind quantum physics, where atomic particles are considered to exist simultaneously in different states, has helped him think about investment strategies performing in uncertain economic futures, he said.

“Also, being an actuary has made me more aware of why I’m investing. The asset management industry has been guilty of not being very curious why people were giving them their money. Understanding clients’ outcome motivations is driven by actuarial training.”

Being based hundreds of miles from London may help the Gars team avoid “groupthink”, and the lack of market noise may help it think longer term, Munro said. Moreover, the quality of life in a city where the countryside is a mere half hour’s drive away is a reason to stay.

But such benefits shouldn’t be overstated, Munro said: “There is a limit to that. [As an employer] you only get a little more time – three, six months extra – to sort things out, before they [employees looking for greater opportunities] move on.

“I suppose I would have been tempted to look elsewhere if opportunities hadn’t opened up. But I’ve been able to have a global career without leaving Edinburgh.”

--A version of this article was first published in FN’s daily newsletter at the NAPF conference last week